Are you glossing over the balance sheet in your financial statements because you’re not sure what the numbers say?
You are definitely not alone.
But that also means you’re missing out on the bigger picture: the net worth of your business, how much money you have, and where that money is kept.
Understanding your cash flow is crucial to managing in a small business.
In this article, we’ll walk you through the basic concepts and explain how to read the statement as a whole and how to easily manage cash flow so you can gain valuable insights into your business.
Here’s what we cover:
What is a balance sheet and why is it important?
It is one of the three core financial statements that help you manage your business’s cash flow.
The balance sheet provides an overview of the state of your company’s finances at a specific point in time, the so-called balance sheet date.
It is generally used along with the other two types of financial reports: the income statement (also called the profit and loss statement or profit and loss statement) and the cash flow statement.
Because the balance sheet reflects all transactions since your company’s inception, it shows the overall financial health of your company.
This will tell you exactly what your business owns and owes, as well as the amount you have invested as the owner.
What it can’t do, however, is give you a sense of the trends that are playing out over time.
This is why you need to compare your current balance sheet with previous balance sheets to see how your finances have changed over time.
Then you can see how far your business has come since day one and whether you have successfully managed cash flow.
The sections of the balance sheet
The balance sheet consists of 3 parts:
- financial assets
- liabilities
- Equity capital
The way they are reflected in the billing is based on the basic accounting equation:
Assets = Liabilities + Equity.
The statement must always be balanced, hence the name.
That’s because your business has to pay for everything it owns (assets) by either borrowing money (assuming liabilities) or taking it from you, the owner (issuing equity).
Let’s take a closer look at each section of the balance sheet.
What are assets?
Assets represent the use of funds. These are all items of value that are owned by your company or are owed to your company.
The company uses cash or other funds provided by a creditor or investor to acquire assets.
The assets on the balance sheet are listed from top to bottom in order of liquidity. It’s that easy to convert them into cash.
You will notice that they are also divided into current assets, fixed assets and intangible assets.
Current assets are those that can be converted into cash in less than a year. This includes bank balances, trade receivables, prepaid expenses and inventory.
Long-term assets consist of fixed assets and intangible assets.
Fixed assets are the use of cash to purchase assets with a lifespan of more than one year, such as land, buildings, machinery and equipment, furniture and fixtures, and leasehold improvements.
Intangible assets are assets with indefinite lives that may never be converted into cash.
Therefore, for most analytical purposes, intangible assets are ignored as assets and deducted from equity because their value is difficult to determine.
Intangible assets include assets such as research and development, patents, market research and goodwill. Intangible assets are similar to prepaid expenses in that you acquire a benefit that is expensed at a later date.
What are liabilities?
Liabilities represent sources of cash or equivalent funds invested in the business by lenders.
Lenders generally include commercial suppliers, employees, tax authorities and financial institutions. This source of funding allows your business to continue or expand operations.
The liabilities on the balance sheet are divided into current liabilities and long-term liabilities.
Current liabilities are obligations that come due and must be paid within 12 months. They are listed in order of due date.
This includes trade payables, accrued expenses, and current portions of long-term debt.
Long-term liabilities are obligations that are due in future years, such as the long-term portion of long-term debt and loans payable to owners.
What is equity?
This section represents the owners’ share of the financing of all assets.
If you add up all of your company’s resources (the assets) and subtract all of the third-party claims (the liabilities), the remainder is equity.
This section usually contains two key elements.
The first involves money paid into the company in the form of an investment in exchange for a certain level of ownership, typically represented by shares.
The second factor is the revenue your business generates and retains over time.
How to read the balance sheet
Before delving into the information on your balance sheet, you must first ensure that it is in balance.
Does the value of your total assets equal the total value of liabilities and equity?
If they are out of balance, you need to investigate the problem. There may be incorrect or misplaced data, inventory errors, or exchange rate miscalculations.
Overall, a positive bottom line means the business has value to you as the owner.
A negative balance sheet means that there were more liabilities than assets, leaving you with no overall value of the company at that point.
Your business may have made a profit in a given financial year and still have a negative balance sheet if there were a series of losses in previous years.
When reviewing your assets, it is helpful to recognize the spread between current and long-term assets.
Are your assets evenly distributed or, for example, is all your money tied up in fixed assets? Distributing your assets can help you identify potential cash flow problems.
When reviewing liabilities, take another look at the distribution of short-term versus long-term liabilities to gain insight into your cash flow.
If you have lent money to the company, the largest creditor could be the shareholder’s loan account.
Another way to extract the information contained in the balance sheet is to analyze the financial ratios.
The main types of ratios that use the balance sheet are financial strength ratios and activity ratios. However, keep in mind that some metrics require information from more than one financial report.
Financial strength ratios provide information about how well your company can meet its obligations.
For example, the debt to equity ratio (calculated as: Total Liabilities / Total Equity) is a ratio that shows your company’s ability to pay off its debts with equity when necessary.
The current ratio (Current assets/current liabilities) will tell you whether you will be able to pay off all your debts in the next 12 months.
Activity metrics focus primarily on current assets to show how well your company manages its operating cycle, including receivables, inventory, and payables.
These metrics can provide insight into your operational efficiency.
Balance sheet versus cash flow statement versus profit and loss statement
The balance sheet shows a snapshot of your assets and liabilities at a specific point in time.
However, you will notice that neither the amount of cash spent nor the profit or sales made are displayed.
This is because the balance sheet does not show your actual financial activities over a period of time. It only shows the results of what your company owns and owes as a result of this activity.
For this reason, to get an overall view of performance, you need to look at all three financial reports.
The income statement summarizes your business’s income, costs, and expenses so you can ultimately understand whether you were profitable.
The cash flow statement allows you to understand how much money came in and out of the company during this period and what it was spent on.
This statement doesn’t so much show the financial health of your business as it gives you clues about where the money is going and how you might be able to budget differently.
Final thoughts
While the balance sheet is only one part of the financial picture, it is critical for managing cash flow, understanding how your business is financed, and the value of the assets held within it.
Familiarize yourself with the information contained in the balance sheet and you will gain numerous insights into your cash flow management and your ability to meet your obligations as they arise.
Editor’s Note: This article was updated in July 2024.
